GFDR 2015 Long-Term Finance. Chapter 2: The Users of Long-Term Finance GFDR SEMINAR SERIES FEBRUARY 9, 2015

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1 GFDR 2015 Long-Term Finance Chapter 2: The Users of Long-Term Finance GFDR SEMINAR SERIES FEBRUARY 9, 2015

2 Use of long-term finance by firms Why would a firm want to use long-term vs. short-term finance? What are the implications for firm performance? Which factors can limit firms access to long-term finance? o o Firm characteristics and evidence Cross-country characteristics and evidence Policy recommendations

3 Why would a firm want to use long-term vs. short-term finance? Match maturity of assets and liabilities: use long-term debt to purchase fixed assets or equipment (Hart and Moore 1995) o Empirical evidence for Ecuador, India, Italy, the UK, the US (Graham and Harvey 2001; Jaramillo and Schiantarelli 1996; Schiantarelli and Sembenelli 1997; Schiantarelli and Srivastava 1996; Stohs and Mauer 1996) Long-term debt minimizes risk of having to refinance in bad times o o Liquidity risk of short-term debt: lenders may be reluctant to refinance if borrower experiences a negative shock or credit market conditions deteriorate (Diamond 1991, 1993; Graham and Harvey 2001) Firms that expect to experience positive shocks may want to refinance debt frequently to obtain better loan terms later (Barclay and Smith 1995; Diamond 1991; Guedes and Opler 1995)

4 What are the implications of long-term finance for firm performance? Theoretical literature is inconclusive on how debt maturity affects investment and firm performance o Long-term debt allows firms to invest in projects that bring in returns in a long time horizon, including new technologies, which may increase firm productivity and profitability (Hart and Moore 1995) o Long-term debt can reduce managers incentives, hampering investment and firm performance (Jensen 1986; Myers 1977; Rajan 1992) Empirical evidence is needed, but it s challenging to identify causal effects vs. correlations o Many studies carefully control for confounding factors, but can still be subject to estimation bias

5 Empirical evidence suggests long-term finance increases firm investment Cross-country study shows a positive relationship between long-term finance and firm performance - unless it is provided in the form of directed credit (Demirguc-Kunt and Maksimovic 1998) Within country evidence on long-term debt and performance is less clear o Positive relationship: Ecuador, India, Italy, UK (Jaramillo and Schiantarelli 1996; Schiantarelli and Sembenelli 1997; Schiantarelli and Srivastava 1996) o No or negative relationship: China, US (Cull, Liu and Xu 2014; Jiraporn and Tong 2010; Li, Yue and Zhao 2009) Within country studies find a positive effect of long-term debt on investment o Studies for the US and Belgium use decline in credit availability during recent financial crisis to assess causal effect of long-term credit on firm investment (Almeida et al. 2012; Duchin, Ozbas and Sensoy 2010; Vermoesen, Deloof and Laveren 2013)

6 Small firms use less long-term finance than larger firms % Average % of Purchase of Fixed Assets Financed from External Sources World Bank Enterprise Surveys o 123 countries o 2006 to 2014 o Firm size defined based on number of employees Lenders often have less information on smaller firms than on large firms, which makes them reluctant to provide long-term debt to small firms (Custódio, Ferreira and Laureano 2013; Magri 2010) 0 Small Firms (< 20) Medium Firms (20-99) Large Firms (> 100)

7 Differences in use of long-term finance across firm size are driven by bank credit use of equity is limited for all firms Sources of External Finance for Purchases of Fixed Assets % Bank Trade credit Equity Other Small Firms (< 20) Medium Firms (20-99) Large Firms (> 100)

8 Firms in developing countries finance a lower share of purchases of fixed assets externally 45 Average % of Purchase of Fixed Assets Financed from External Sources World Bank Enterprise Surveys o 123 countries o 2006 to 2014 o Representative at the country level % o Broad coverage of low and lower middle income countries (not many high-income countries) 5 0 High Income Upper Middle Income Lower Middle Income Low Income

9 Firms in developing countries have fewer long-term liabilities than firms in high-income countries % Median % of Firms Reporting Any Long- Term Liabilities Balance sheet data from ORBIS (Demirguc-Kunt, Martinez Peria and Tressel 2015a) o 87 countries o 2004 to 2011 o Data not necessarily representative of firms in each country 20 0 Small Firms (< 20) Medium Firms (20-99) Large Firms (> 100) o Mostly includes high-income and upper middle income countries Developing Countries High-Income Countries

10 Firms loan maturities are shorter in developing than in high-income countries 70 Average maturity of loan or line of credit World Bank Enterprise Surveys o 43 countries o 2006, 2007, and 2009 Months o Duration of firms most recently received loan or line of credit High Income Upper Middle Income Lower Middle Income Low Income

11 Macroeconomic and political stability are associated with greater use of long-term finance Low inflation, little corruption, and strong property rights protection imply lower country risk and lower price of long-term debt o Beck, Demirguc-Kunt and Maksimovic (2008), Broner, Lorenzoni, and Schmukler (2012), Demirguc-Kunt and Maksimovic (1999), Fan, Titman and White (2012)

12 Financial development matters for firms access to long-term finance Source: Demirguc-Kunt, Martinez Peria and Tressel (2015a)

13 Sound legal institutions can increase firms use of long-term finance Sound legal institutions allow lenders to enforce claims and reduce need to rely on the disciplinary role of short-term debt Creditor rights, bankruptcy laws, overall contract enforcement, efficiency of the legal system are correlated with use of long-term finance o Bae and Goyal (2009); Demirguc-Kunt and Maksimovic (1999); Demirguc-Kunt, Martinez Peria and Tressel (2015a); Fan, Titman and White (2012); Kirch and Terra (2012); Qian and Strahan (2007) Gopalan, Mukherjee and Singh (2014): debt recovery tribunals in India caused firms to use more long-term debt instead of short-term debt o Causal estimates based on variation in introduction of the debt recovery tribunals across states and time

14 Information sharing through credit bureaus fosters long-term finance Information sharing through credit bureaus reduces lenders need to monitor and discipline firms through short-term debt (Magri 2010) Firms average loan maturity lengthens after the introduction of a private credit bureau, but not after the introduction of a public credit registry (Martinez Peria and Singh 2014) Months Average loan maturity Year Most credit bureau reformers introduced a credit bureau in 2004 or 2055 Credit bureau reformers Non-reformers

15 Collateral registries for movable assets can help firms obtain long-term loans Firms often need to post assets as collateral for long-term loans o Movable assets, such as machinery or equipment, typically account for a large share of assets o Banks in developing countries may be reluctant to accept movable assets if these are not listed in a registry Introduction of registries for movable assets is associated with an increase in the maturity of bank loans to firms (Love, Martinez Peria, and Singh 2013)

16 Good corporate governance can allow firms to use more long-term debt Monitoring firm managers through independent boards and stronger shareholder protections can substitute for monitoring through short-term debt Corporate governance reforms that improve shareholder rights are associated with a decrease in short-term vs. long-term debt (Anginer, Demirguc-Kunt, Maksimovic, and Tepe 2015)

17 Policy recommendations regarding the use of long-term finance by firms Governments should strive to provide o A stable political and macroeconomic environment o A contestable, well regulated financial system o Sound legal institutions for contract enforcement o An effective corporate governance framework Specific institutions that have been shown to foster use of long-term finance by firms include o Credit bureaus o Collateral registries for movable assets Financial development matters for firms access to long-term finance o But subsidies, directed credit, and government banks are likely to backfire

18 The Use of Long-Term Finance by Households

19 Use of long-term finance by households Why would households want to use long-term financial instruments? What are the risks associated to the usage of long-term finance? Who uses long-term financial products? Which factors can limit household usage of long-term finance? Policy recommendations in promoting long-term finance by households

20 Why would households want to use long-term financial instruments? LTF allows households to protect from life-cycle challenges (Yaari, 1965; Davidoff, Brown and Diamond, 2005) o Longevity/aging: products to save for retirement o Health shocks: health and long-term care insurance products o Death of breadwinner: life insurance products LTF facilitates lumpy purchases such as housing o As collateral, housing allows to smooth consumption (Lustig and Van Nieuwerburgh, 2004) and can facilitate business start (Adelino, Schoar and Severino, 2013; Wang, 2012) LTF allows for longer-term investments such as human capital o Theoretical and empirical evidence on the sensitivity of human capital accumulation to borrowing constraints (H. Jacoby, 1994; H. Jacoby, E. Skoufias, 1997; K. Beegle and others, 2003) Long-term saving instruments allows saver households to reap term premium (Merton 1971, 1973)

21 What are the risks associated to the usage of longterm finance? Borrowing and investing in LTF markets also entail risks o o Vulnerable consumers can be marketed financial instruments that they do not understand and are unable to service Evidence on pension, mortgage and insurance markets suggests that lack of information of consumers together with incentives of financial providers who want to exploit short comings in understanding leads to substantial errors in financing choices (Hastings and Tejeda-Ashton, 2008; Lara-Ibarra, 2011; Rocha and Rudolph, 2010) Active government interventions to promote greater household participation may backfire, as in the case of U.S. subprime mortgages o A key contributing factor to the subprime mortgage crisis in the U.S. was the overextension of credit to noncreditworthy borrowers and the relaxation in mortgage-underwriting standards (GFDR 2013, GFDR 2014) o As a consequence, many homeowners in the U.S. took out mortgages exceeding their means (Mian and Sufi, 2009; Mian and Sufi, 2011)

22 Insurance markets across countries Depth and size of insurance markets varies substantially among low and high-income countries Erik Feyen, Rodney Lester, and Roberto Rocha (2011) o Annual data for 90 countries for the period o Study compiles data from sources including: AXCO, IMF, WDI and national sources

23 Main drivers explaining cross-country differences in the development of insurance markets Findings from several cross-country studies suggest that the most important predictors of the size and growth of the insurance sector are*: Income and inflation Population and population density (proxies for larger markets and pools to share risks) Source: Erik Feyen, Rodney Lester, and Roberto Rocha (2011) Institutional factors such as: o the existence of private competitors o solid legal frameworks o developed credit and bond markets * Erik Feyen, Rodney Lester, and Roberto Rocha (2011); Beck and Webb (2003); Donghui and others (2007); Browne and Kim (1993)

24 Mortgage markets across countries Mortgage depth and penetration indicators show that housing finance markets are severely limited in many countries Mortgage depth Mortgage penetration Mortgage depth is less than 10% for most countries Only few countries (Denmark, Switzerland, the Netherlands) have mortgage depth higher than 80% In 50% of countries, less than 4% of adults have an outstanding loan to purchase a house Anton Badev, Thorsten Beck, Ligia Vado, and Simon Walley (2013) o Data for up to 148 countries compiled from Global Findex and from countries central banks, financial regulatory/oversight agencies, or housing finance agencies

25 Main drivers explaining cross-country differences in the development of mortgage markets Cross-country empirical studies on the determinants of the development of mortgage markets find that*: Unlike the banking system, the mortgage sector tends to develop only when countries reach higher income (lower inflation) levels Stable macroeconomic conditions are a critical element for the development of mortgage markets Stronger creditor rights, collateral and bankruptcy laws are positively linked to more developed mortgage markets Source: Housing Finance Information Network (HOFINET) Government-owned banks and regulatory restrictions on banks real estate activities are negatively associated to the development of this market *Badev et al (2013), Warnock and Warnock (2008)

26 Usage of insurance products among households Even within a region or country, usage of insurance products remains higher among wealthier, more educated households But disparities in usage of insurance products by households vary by country/region Percentage of adults with health insurance by income quintiles and education in ECA and LAC 50% 40% 30% Europe and Central Asia 50% 40% 30% Latin America and the Caribbean 20% 20% 10% 10% 0% poorest 20% second 20% middle 20% fourth 20% richest 20% 0% poorest 20% second 20% middle 20% fourth 20% richest 20% completed primary or less secondary completed tertiary or more completed primary or less secondary completed tertiary or more Source: 2011 Global Findex Data

27 Usage of mortgages among households Even within a country or region, the fraction of adults with a mortgage is higher among higher income households 12% 10% 8% 6% 4% 2% 0% Percentage of adults with a mortgage poorest 20% second 20% middle 20% fourth 20% richest 20% East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa South Asia Sub-Saharan Africa High Income 35% 30% 25% 20% 15% 10% 5% 0% Source: 2011 Global Findex Data

28 Market failures that can explain within-country differences in the usage of LTF products Lack of financial awareness, financial literacy and product transparency o Growing evidence shows that financial illiteracy may restrain households from using financial products or from managing them correctly (Hastings and Tejeda-Ashton, 2008 ; Lara-Ibarra, 2011) o People with low levels of financial literacy think less about retirement and most of them have not planned for retirement at all (Lusardi and Mitchell, 2009) o People who make mistakes in interest and future value calculations tend to borrow more and save less (Stango and Zinman, 2009) Challenge: Financial education may be important, but there is a considerable knowledge gap in how best to deliver it Recent randomized control trials (RCTs) can help draw some lessons on recommended delivery mechanisms and intervention features

29 Evaluation of a High-school financial education program in Brazil Bruhn, de Souza Leao, Legovini, Marchetti, Zia, 2011 Fraction of students who save money for future purchases rather than buying on installments School-based intervention targeted to the youth o opportunity for repeated instruction and exercises that allow for sustained learning Intervention spanned 17 months and had positive effects on spending behavior o Students from treated schools more likely to save for future purchases o Effects persisted for the second follow-up (16 months later)

30 Evaluation of Financial Education through South African Soap Opera Berg and Zia (2013) o Innovative delivery channel of financial education o financial education through a popular television soap opera in South Africa, Scandal! One of the main characters borrowed excessively through shop credit, gambling, and falling into a debt trap; and eventually seeking help to find her way out Individuals in the treatment group borrowed significantly more from formal sources and through longer term debt compared to the control group Entertainment media can be an effective tool for influencing key financial decisions

31 Evaluation of Financial education short modules in Mexico City Bruhn, Lara and McKenzie, 2013 Median Savings Account Balance Evaluation of voluntary and free financial education courses offered to the general population in Mexico City Half a day course that consists of modules on saving, retirement, credit cards and responsible use of credit Participation rate was low (18%), even among the sample of interested individuals Six months after attending training: o No impact on borrowing behavior o No impact on awareness of retirement products o No impact on retirement savings Saving outcomes improved modestly, but administrative data suggests that the savings impact is relatively short-lived

32 Policy recommendations in promoting long-term finance by households As with firms, government policies to promote long-term finance for households should focus on: Maintaining a stable macroeconomic environment such as low inflation and a sound macroeconomic framework Promoting financial institutions and markets that are competitive and stable by introducing regulation for healthy entry and exit, and by promoting strong institutional framework for contract enforcement Addressing markets failures and removing policy distortions. In particular for households: Strengthening financial literacy, consumer regulation, disclosure rules and provision of investment default options Delivering financial education is challenging. Evidence suggests that comprehensive courses targeted to groups that might benefit more tend to achieve better results